SAN FRANCISCO — As California enters its fourth year of drought this month, state and local water agencies will continue to maintain credit quality as long as they have flexibility to adjust rates, market experts say.
"The drought is serious and in the long run it can have impacts, but the way everybody should view these credits is that water is an essential service-probably the most essential service," said Craig Brothers, a portfolio manager at Bel Air Investment Advisors LLC.
"You'd have to go to a real dire scenario where water bills aren't being paid or the conservation is reduced to such an extent that their revenues fall to where there's an impact," he said. "We don't see that happening."
Gov. Jerry Brown declared a state of emergency in January and called for a 20% reduction in statewide water use. So far, conservation efforts have come up short, but water agencies can expect an approximate 10% sales volume decline, according to Moody's Investors Service.
The agency, which maintains a stable outlook on the sector-at least for the near-term-said the state's water utilities will be able to offset the decline with rate increases.
California municipal utilities enjoy unlimited authority to adjust rates without outside regulatory approval.
The utilities must inform users of their right to protest proposed rate increases, but this has not proven to hinder rate increases in the past. The threshold for an effective protest under California law is 50% of ratepayers.
According to a recent Moody's report, water and sewer utility rates are expected to increase in fiscal 2015 and 2016 by an average of 5.4% and 4.1%, respectively, which will offset the 10% sales volume decline.
Overall, Moody's said the drought is expected to have little impact on the financial health of water utilities.
"That's the same outlook that we take," Brothers said. "As long as they have the flexibility to adjust rates when there's a decline of water sales due to conservation, as a bondholder you're protected."
The market seems to agree, judging by demand for a state water bond deal this week.
The
Yields on the bonds ranged from 0.86% with a 2% coupon in 2018 to 2.84% with a 5% coupon in 2032.
"The deal's got terrific demand," Brothers said on Tuesday. "We didn't participate in the deal because we thought it was priced too aggressively. That doesn't mean we don't like the credit, we just didn't like the way it was priced."
He said the DWR credit is stronger than a typical water utility bond because it has 29 participating water utility agencies that are obligated to make payments, regardless of the amount of water delivered.
Those payments are equal to operating and maintenance costs and at least 1.25 times aggregate debt service, according to the preliminary official statement.
In the broader market, the drought and conservation efforts have not had a significant impact among investors, according to Rob Williams, director of income planning for the Schwab Center for Financial Research.
Williams said he hasn't seen a major reaction, other than questions about whether investors should be taking some action.
"The advice we're giving to our clients is that most of the investment grade, highly rated municipal utilities in California are able to deal with the short-term demand issues by raising rates," he said. "The credit quality appears to be relatively stable."
Like California's DWR, many of the larger local water providers in the state are also rated highly-in the double-A to triple-A range-and are "well-positioned" to deal with drought challenges, according to credit rating agencies.
For example, the Metropolitan Water District of Southern California, Orange County Water District, and East Bay Municipal Utility District are all rated AAA by Standard & Poor's and Aa1 by Moody's.
The Metropolitan Water District, which provides water to about 19 million people, has unadjusted debt service coverage of 2.4 times and about 1.7 years of annual water delivery in storage. The Orange County district has 2.2 times debt service coverage and 1.5 years of water in storage, and East Bay MUD has 1.7 times debt service coverage and 2.2 years in storage.
Large double-A rated water providers include the Los Angeles Department of Water and Power, the Santa Clara Valley Water District, and the San Francisco Public Utility Commission.
"In terms of the drought's impact on debt service coverage, it seems most of the highly rated utilities at least appear to be pretty resilient as far as the way they raise rates to cover it," Williams said.
According to a Moody's survey of some of its water and sewer utilities, the average projected debt service coverage for the next two years are well above the agency's current 1.88 times median nationwide. Even with a 10% decline in revenues, the average coverage would still remain "sound," Moody's said.
There are, however, a handful of water utilities that have debt service coverage levels below the national average, including Sierra Madre Water Enterprise at 0.3 times. Sierra Madre is rated speculative-grade Ba1 by Moody's.
Other agencies with low debt service coverage include the Central Basin Municipal Water District at 0.65 times, the Antelope Valley-East Kern Water Agency at 0.95 times, and the Contra Costa Water District at 1.4 times.
A water utility's ability to manage rate increases is a major factor in determining its credit strength. Those that have managed increases well and have more flexibility to continue to raise rates tend to be the strong ones, according to Williams.
"Those that have already pushed the envelope too far and have rates that aren't competitive or are punitive to usage may have a sharper drop in their usage, which would impact their revenues," he said.
Williams is more cautious about utilities in more agriculturally focused regions that have been dramatically impacted by the drought, like those in the Central Valley.
"These probably have less flexibility in diversification of ratepayers and are likely more exposed to a drop in usage from a lot of the agricultural users," Williams said. "That might be an area where we suggest more scrutiny for people who have exposure to the smaller issuers."
According to Fitch Ratings, southern California utilities have taken measures in the last 20 years to increase storage capacity, making them better prepared for a drought. However, utilities in the Northern and Central Valley have fewer storage facilities and are more reliant on non-adjudicated groundwater supplies, which continue to decline.
All three credit rating agencies have been monitoring the drought situation and have continued to maintain mostly stable outlooks on the water utility sector, saying the drought is not likely to pressure ratings.
Moody's said that individual credit quality trends will vary, but it anticipates the sector on average will maintain a stable fiscal profile through at least 2016.
"Additional factors such as the potential continuation of the drought, the extent of water conservation and stored water availability, and utilities' continued willingness to adjust rates will be critical factors in assessing the drought's credit implications beyond 2016," analysts said in a recent report.
Fitch also said the drought is not likely to pressure ratings, but could down the road if the severity and duration of the drought were to result in sustained weakness in utility credit quality.
Standard & Poor's has said that along with implementing water rate structures to promote stable revenues, increasing water storage capacity and developing new, stable water resources are key to the future stability of the water sector in California.
So far, the drought has increased support for infrastructure investments, particularly water storage projects. After months of debate, the governor and the state legislature were able to pass a
More recently, Brown signed legislation designed to create a framework for sustainable, local groundwater management.
The new regulations will require municipal entities to develop sustainability plans for over-drafted basins, and direct local governments to manage their groundwater resources through metering and penalties.
According to the state, its groundwater accounts for approximately 30% to 46% of the state's total water supply, depending on the annual rainfall.
